OPTIONS – IT’S ALL GREEK!!

OPTIONS – IT’S ALL GREEK!!

If you are a finance student or an Option trader, you must be well versed with the concept and significance of Option Greeks. But for the uninitiated, any discussion on the same is likely to seem, well, ‘all Greek’.

Why options are adhered to Greek and how its related to stock market

The price of an Option is influenced by a number of parameters, namely Price of Underlying asset, Volatility and Passage of time and Interest rate. In simple terms, Greeks are a set of ‘risk measures’ that describe the sensitivity of an option’s price to a change in each of the underlying risk factors.

The Greek Connection

Since all the sensitivity measures w.r.t. Options are denoted using Greek letters, they were given the name “Greeks”.  Ever wondered why Greek symbols and letters are extensively used in various fields like physics, mathematics and finance e.g. Pi, Theta, Lambda, Alpha, Beta.  This is because the ‘small letter’s of Greek alphabets fulfilled the need for having unique and distinctive symbols for a range of constants & variables.

Furthermore, another Greek connection can be traced back to 332 B.C. when the first Option contract was established. In his book ‘Politics’, Aristotle talks about an astronomer Thales who formed a Call Option with olive presses as an underlying asset based on his prediction of a bountiful olive harvest in the coming year. He established the contract using a token money and cashed on the abundant harvest by selling the rights to use these olive presses to other parties.

Also Read : Vega – an Option Trader’s lifeline

A Primer on Greeks

For any option trade to be profitable, it is absolutely imperative to understand the meaning of each of the Greeks as well their interactions with each other. Some of the Greeks can impact the trade position positively whereas others may simultaneously work the opposite way.

Delta is the most important Greek which determines the rate of change of the price of an option due to a change in the price of the underlying asset (stock or commodity). For an asset with a delta value of 0.5, if the price of the underlying stock goes up by 100% then the price of the option will go up by 50%. While Call options have a positive relationship with the underlying asset, Put options exhibit a negative delta

The below table gives you the range of delta for call & put options as well as how the delta changes with the ‘moneyness’ of an option.

 

Call Option Put Option
In the Money 0.5<Delta<1.0 -1<Delta<-0.5
At the Money 0.5 -0.5
Out of Money 0<Delta<0.5 -0.5<Delta<0

The other first-order Greeks are Vega, Theta and Rho which denote the sensitivity of an option value to change in Volatility, Passage of time and Interest rate respectively. The Greeks are of critical importance in risk management by financial institutions as they set risk threshold values for each of the Greeks which must not be exceeded.An important property of Delta is that the delta of an option portfolio with a number of positions can be calculated by adding up the deltas of individual option positions. Since Delta presents the largest risk to an option portfolio among all Greeks, many investors and financial institutions attempt to create a portfolio with a zero delta by employing hedging techniques. For any hedging to work effectively, it is necessary  to understand that Delta value is prone to changes as the price of underlying asset changes which is represented by Gamma, a second-order Greek (measure of how a first order Greek changes with respect to a variable of influence). Furthermore, Delta changes with change in volatility and as the time to expiration of the option shortens. In our next blog we will look into the first four derivatives of Greek in detail.

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